Saturday, March 15, 2014

The Finance Macro Canon

Stop me if you've heard this one before:

1. Inflation is caused by increases in the money supply. If the Fed expands the monetary base ("prints money"), the new money may sit for a while in the bank, but will eventually make its way into the broader economy, at which point it will cause inflation.

2. QE represents money-printing, so it will eventually cause inflation. In fact, it probably already is causing inflation - have you been to the store lately and seen the price of a gallon of milk? And don't you know that they changed the way they measure inflation, meaning it's much higher than the official numbers suggest?

4. Additionally, QE is a stealth bailout of big banks. This will increase their risk-taking via moral hazard and precipitate another financial crisis.

5. QE depresses interest rates, encouraging investors to "reach for yield" by investing in risky assets, increasing the likelihood of another financial crisis.

6. Government borrowing requires the Fed to buy bonds to hold down interest rates and keep the government from defaulting; this will cause/is causing/is defined as inflation.

7. Every bad effect of QE will also result from a long period of zero interest rates.

I have heard this basic story from many employees in the financial industry. I have heard it from a large number of finance writers, including some people I like and respect (but also including some who are shameless hucksters). I have heard it from undergrads at Stony Brook and Michigan. I see it on Twitter and on the blogs and on TV, and I hear it in Wall Street bars. I call it the Finance Macro Canon - the basic framework through which a big chunk of Wall Street sees the macroeconomy.

What I think about each of these belief items is not important (Just for the record, I think #4, 5, 6, and 7 very well might be true, #3 is goofy, #2 is utterly wrong, and #1 is one of the biggest mysteries of macroeconomics). The really interesting question is why the finance industry has become such a hive mind with regards to this worldview.

First of all, part of this canon defies the data - Japan's eternal zero interest rate policy didn't end deflation, nor did a dramatic expansion of its monetary base in the 2000s. And America's "money-printing" and ZIRP haven't done much to budge inflation. Second of all, the canon goes against the bets of the finance industry itself - inflation expectations, as measured by TIPS breakevens, are around 2%, even in the long term.

This, I think, is why the Shadowstats BS - or its cousin, the "have you seen the price of a gallon of milk lately" BS - is so crucial to the Finance Macro Canon (FMC). Humans have cognitive dissonance - it's difficult for us to take actions that don't jive with our beliefs. So subscribers to the FMC have to tell themselves that CPI isn't actually real inflation - that's the only way to reconcile their bet on low CPI with their belief in the theory that QE and ZIRP cause inflation.

But why patch up the FMC with obvious BS like Shadowstats? Why not just alter it to include the possibility that QE and ZIRP don't always cause inflation, even in the long term? In other words, why is the Finance Macro Canon such a canon in the first place?

Here are a few candidate hypotheses, arranged from (in my opinion) the most rational to the least:

1. History. Throughout history, currency debasements have often resulted in inflation. In the 70s, easy monetary policy (money printing) did indeed seem to result in high inflation in the U.S. And when Volcker tightened policy, inflation fell. Why should this time be different?

2. The lingering influence of Milton Friedman and the monetarists. Friedman told us that easy monetary policy causes inflation. His insights form the core of the New Keynesian research program that has come to more-or-less dominate central bank thinking.

3. The lingering influence of the Austrians. Austrians traditionally are suspicious of big banks, and suspicious of government meddling in the economy. Peter Schiff calls himself an Austrian, and he's out there spouting this canon daily, and lots of people listen to him.

4. Motivated reasoning. Most of the retail clients of the finance industry - and the customers of financial media - are older high net worth individuals who stand to benefit both from higher interest rates and from lower inflation. It might be in the interests of financial industry employees and financial media people to express a worldview where the policy conclusion is exactly what their clients and customers would like, while simultaneously placing bets against this worldview.

5. Need for the Illusion of Knowledge. A world in which printing money doesn't have any clear link to inflation is a weird world indeed. Instead of casting themselves adrift on the sea of existential uncertainty, finance industry and media people might subconsciously choose to cling to the shores of certitude.

So how does one extract an individual human mind from this hive mind? That is always a tricky undertaking. But I've found two things that seem to have an effect:

Method 1: Introduce them to MMT. MMT is a great halfway house for recovering Austrians.

Method 2: Introduce them to the research of Steve Williamson. Williamson is an example of a guy who changed his mind about the most likely effect of QE, after observing its real effects.

So far, these are the only things I've found that work. If you have any other ideas, please share. Every mind we reclaim from the hive is another blow struck for rationalism, individuality, and optimal monetary policy (whatever that is).

113 comments:

Great post Noah, something that has puzzled me as well every time I hear discussions of "money printing" even in your most basic and less biased outlets like Reuters or Bloomberg. The tricky bit for many people I think is that as long as the central bank is willing to pay interest on its liabilities, then these liabilities become more like credit than money. Central banks' willingness to do QE was probably solidly anchored in new keynesian thinking I think of the cashless economy variety. That version of the new keynesian model (popularised by people like Mike Woodford) is profoundly anti monetarist in many ways. It is different I think from the new keynesian models underlying the thinking of Miles Kimball or Greg Mankiw, who still think of binding cash in advance constraints. It is more appropriate in a quasi-electronic money, modern payments system economy. But a lot of people probably still take the quantity of money identity P*Y=MV and assume for some reason velocity V must be constant. Then you apply this with the official definitions of monetary aggregates like M1 and you get a prediction of high inflation whenever central bank liabilities explode or the amount of deposits in the banking system increases a lot. Incidentally, if you do work with a quasi-cashless economy model, and the central bank suddenly decides to not pay interest on excess reserves even when market interest rates increase significantly above zero then that would cause high inflation since the real value of these excess reserves must be very low in that case (demand for excess reserves must be small if they don't pay competitive interest rates and we're no longer in a financial crisis). But the fed and other central banks' commitment to their inflation target suggests Janet Yellen or Mark Carney would never do such a crazy thing, and the losses on the fed's portfolio when interest rates rise have been estimated to be modest (look up a paper by Hall and Reis for some estimates).

well, if money printing do not create inflation per se, then we should study whats going on in countries like Argentina or Venezuela, that experienced a huge money printing base money since a decade, that are trying to suck it through taxes (increasing public taxes), but are not getting rid of high inflation (1.200% accumulated in Venezuela since 1999-2012).

Wow. Just wow. So you get a fancy degree in economics - and this is what it does to your brain.

Let's see

1. Inflation is caused by increases in the money supply.

Seeing as how the Fed made it very clear that the increase in the money supply will be TEMPORARY, it shouldn't surprise anybody that it wouldn't result in inflation. Apparently, it takes a degree in economics to think of it as one of the biggest mysteries of macroeconomics

And then

5. QE depresses interest rates

Wow. Just wow. How deep inside the keynesian bubble do you have to be to agree with such a thing ? Because over here in the real world, money-printing actually increases interest rates.

7. Every bad effect of QE will also result from a long period of zero interest rates.

See above comments.

Japan's eternal zero interest rate policy didn't end deflation

I take it that in Noahworld rain is caused by puddles on the ground. Because from where I stand, it's the deflation that causes zero interest rates. Ya know, like in the 1930s.

Was money easy or tight during the 1930s ? How about the 1970s ?And what exactly was the interest rate during the 1930s ? Oh yeah, ZERO !What about the 1970s ? Interest rates were pretty high back then, weren't they ?

So what kind of economist looks at interest rates as an indicator of monetary policy stance ? I'd say an incompetent one.

this post is absolutely hilarious because it appears to be written by an inflationista who's hilariously going on the offensive about the very things that Noah's beating down in the first place, yet treating them as "evidence" for why Noah's a CRANK. hahahahahaa! reading comprehension much?

#1 doesn't seem like much of a mystery to me--it seems flat out wrong, because it's only looking at one part of the equation.

Currency is not wealth itself, but a tool to exchange wealth from one person to another. So what's really important is how much wealth was created, in the form of new buildings, software, phones, and other goods and services, in the last 20-30 years relative to how much the monetary base--i.e., the medium of exchange--grew.

If the monetary base did not expand at pace with the growth of actual wealth in the form of goods and services, then we would reach a disequilibrium where demand for money outpaced supply, thus giving us the ability to print a ton of currency without actual inflation.

I'd argue this is exactly what has been the case in the world for the past 20-30 years. We have tons of beautiful skyscrapers built during the 2000s, both in America and globally. We have smartphones, e-commerce, YouTube videos, economist blogs...all sorts of real enriching goods and services, but not the growth in currency to match our need to trade this sudden explosion in wealth.

We won't fix this problem anytime soon because people misunderstand what money is: it isn't wealth, it is a symbol of wealth. This is unsurprising. In the 1500s, Europe fought itself over a debate about whether symbols in churches were false gods (the Protestant view) or symbols of the one true God (the Catholic view).

Humanity's inability to understand semiotics is going to be ruinous for our economy for generations.

So, Prof. Smith, my recommendation is this: team up with cultural theorists and linguistics. Try to focus the discussion on what money is, and encourage people to see it as a medium of wealth and not wealth itself.

Every mind we reclaim from the hive is another blow struck for rationalism, individuality, and optimal monetary policy (whatever that is).,,,you need let's see ...more 20,000,000 of minds at least before the big crush

1. Inflation itself is odd, as prices do not necessarily rise uniformly. Prices rise on the individual product level for either increases in demand or increases in costs. The method that the Fed used was QE which is a highly inefficient method of boosting the money supply. Because it involved a transfer of money for financial products. Both sides were left with the same net worth. Essentially the Fed became more levered and the bank less so. QE is not real money printing. The issue at hand is how to measure money, with reasonable predictable inferences. There is no mechanism for bank money to become broad economy money. The banks who got the money buy financial assets, not economy assets. We have predictably seen a massive rise in financial asset prices, which we call asset inflation. It would have been far more efficient to give each American $10,000 in 2008-2009. Inflation is not caused by numbers, but by human emotions and beliefs. Mass fear, panic, loss of faith, words from politician's mouths.2. Oil has largely been in check the last few years as well as labour costs, and they are the input cost to many things. I'm unsure on this question, whether the bean-counters are accurately taking prices or not.3. Arguing about definitions are a waste of time, we could call "a general rise in prices" ABCD. In the mean time Austrians should just accept the mainstream definition of inflation as a rise in prices to keep the dialogue going.4. No brainer. "Let me buy all your assets at super inflated prices."5. No brainer. The decrease in interest rates also causes companies to buy back their own stock as the earnings yield is significantly greater than the borrowing rate. This causes a decrease in the amount of financial assets available for everyone, and thus higher prices. Whether or not it results in another financial crisis is much harder to determine because these things can last forever, especially with a red bull Fed at your back.6. This is certainly not defined as inflation. The government is in such gigantic debt that these policies must continue, unless they just buy everything back with printed cash, which is looking more likely.7. I'm very weary of the bad effect is eventually gonna happen crowd.2.3. Arguing about definitions are a waste of time, we could call "a general rise in prices" ABCD. In the mean time Austrians should just accept the mainstream definition of inflation as a rise in prices to keep the dialogue going.

NO you don't have only asset inflation. you have plenty of consumer good's inflation all around the world ,,,,you american's are exporting inflation with your bonds that give extra purchasing power to million's of asians that buy your inflated assetsergo bread is rising in the north-african regions, olive oil in the south of europe doubled since 2008Tuna prices arise 40% since 2010 ,,,,is a scarcity game and we are losing

and of course the ukranian's and others are losing more than money or purchasing power

Re #4, I don't think QE is intentionally designed as a bailout of the big banks, but this is what it turns out to be in practice. So here s what I don't get about the finance types (and I agree with you, Noah, about this being how the finance types see the world): If the Fed is going to float all their boats for them, what the hell are they bitching about?

I mostly agree with your characterization, and I think it extends very far up the finance industry continuum. Many of the smartest hedge fund managers, for example, seem to rely on some version of this framework. I would add one important reason to your "why" list:

6. The feeling of contrarian, but still tribal, correspondence is usually very rewarding, especially in the finance industry. This is especially true when the contrarian view is pessimistic (as opposed to, say, contrarian climate change denial or the contrarian view the the ERP should be 50 bps and the S&P should be at 5000). Pessimism often acts as signal in the financial industry -- including journalists -- for "I am not an optimistic snake oil shill or a thoughtless lemming lacking historical context." When popular threads of pessimism emerge in areas where the empirical stories are complex and meandering, there are network effects.

I think the particular canons come ab initio as you describe -- tribal associations with hyperbolic perceptions of Austrian and Monetarist thinkers and empirical generalizations ... and then expands into the genuinely smart (say Seth Klarman or Paul Singer or David Einhorn) or thought to be smart (say ZeroHedge or Peter Schiff) tribal representatives. I call it a network effect because as in your point 5 -- the reward of correspondence that helps create cognitive dissonance in all areas is ferocious in finance. I can say from experience that finance practitioners or even journalists often start off as hedgehogs and find themselves to have accidentally become foxes (they come to realize they are implicitly expressing very complex opinions embedded in their bets or are assumed to be experts on such issues by others). Confusion is often a bad feeling, but persistent confusion in this situation is especially unsettling -- "am I a fraud?" The pain of incongruity can really fence in an established, skeptic-signaling story when incongruity can run straight through your identity and reputation.

Obviously what's also required here is enough complexity or market efficiency that being wrong doesn't predictably matter enough to overcome these forces. After all, even if you claim a 50% chance of armageddon your actual bets get market lottery-odds and your reputational bets are not rewarded symmetrically. Even if or when it might be possible to make better investment decisions with a better macro framework amid some kind of inefficient pricing, those outcomes would still be incredibly noisy and thus relatively weak feedback compared to the stronger network effects.

much of your financial analysis goes over my head, but i'm interested in how your prose borrows from communications tech, eg, network effects, signal, noise, feedback, etc. this terminology brings to mind the metaphor of "stochastic resonance," eg, when random noise serves to tune a particular signal. (the example of a weak am radio signal, in which the static accentuates rather than obscures a song.)

if the analogy is apt, an astute observer should be *more* able to discern information from chaotic chatter than from times of seeming clarity,

Economists never learn, do they, Prof Smith? Milton Friedman predicted that the sharp rise in M1 in 1983-84 would result in sharp inflation. It did not happen. The reason was obvious, though. The increase in money supply went to boost the prices of financial assets as a look at the stockmarket indices for those years would show.

But surely there is nothing surprising in this. Except to economists, of course. One would think that Fisher had never written his famous equation MV + M'V' = PT. When you go to a supermarket and buy a loaf of bread you pay for it with dollars. When you buy bonds or shares or flip houses you pay for it with dollars. Is this really so hard to understand?

Take a look at http://www.philipji.com/M1-and-Mc/. I will be surprised if you can point out any period when Mc does not match the movement of the economy; and this is over a period of five decades. The explanation for Mc can be seen in http://www.amazon.com/dp/B0080WPK2I. But it's best to postpone reading it until the next crash.

Come on Noah. I think you're deliberately excluding Market Monetarism here as an alternative idea. The basic flaw with #1 and #2 is that they fail to incorporate permanent vs. temporary monetary injections (or "forward guidance" as you like). That is a distinction that is part of basic New Keynesian theory but has only been harped on by the MMs for the past 5 years.

The perspective of someone who has worked in Banking as well as "Wealth Management":

1. In those industries it is safer to "say what the rest of the crowd says" than it is to devise your own opinions.

So if a lot of people say that QE = inflation, your safest bet is to say the same thing.

That way, even when inflation does not come, your predictions won't have been any worse than those of your competitors and you can tell your clients "Hey, that's what everyone else thought was going to happen too."

On the flip side, if you say that inflation won't come and it DOES, you are screwed because your clients will wonder why the heck you weren't smart enough to see it coming when everyone else did.

Bottom line is that there is this loop which compels people to say what everyone else in the industry says because there is safety in numbers.

2. People in these industries have taken micro and macro at the undergrad level and that's it.

They don't read Gautti Eggertson or Mark Gertler or other contemporary economists writing research papers on these topics.

And why don't they?

Because they think they already have the right answers and don't feel the need to go and seek out new answers. And again- there is safety in numbers.

Why try to figure out liquidity traps when everyone else is saying inflation is coming? Just say the same thing and if inflation doesn't come... oh well. It's not like your clients will be able to say "Hey look, your competitor made a different prediction and he was right, I'm taking my money there".

That's NOT an indictment of bankers or anything. There are good reasons they behave as they do and it's due to the incentive structure and institutions in which they operate.

There is a strong, strong incentive to agree with your clients in finance.

Believe it or not, rich people have opinions on everything and their opinions tend to go along with what's in the popular media.

And so if you are managing $10 million for some lawyer, he WILL come into a meeting one day and say that he believes QE = inflation because he watches CNBC. Protect me against inflation, he says.

What do you say?

Even if you have read all the research and read Noahpinion, are you really going to bet against your own client and/or try to convey to him what you've learned from Noah?

No way.

You are going to agree with him because you are better off agreeing with your client and turning out to be wrong than disagreeing with him and turning out to be wrong- the latter gets you fired. The former just gets you some stern words about how you are supposed to be the smart one and provide the expertise and you should have known better. But that's not too bad.

The Fed can either control inflation or it can't. If it can, inflation is irrelevant. It is incredulous to think the Fed has suddenly changed and now wants only inflation. If it can't, then it must be the result of real effects in the economy that also affect interest rates and involve growth and they are irrelevant. .

So if I understand this properly , every mind rescued from the hive should add to the pool of people who compose posts like the one above , or comments like those above. Let me think about that a sec............

RUN , HIVE MIND , RUN FOR YOUR LIVES!!!! ( that is , away from the rescuers )

"Inflation" is the net result of inflationary and deflationary forces. Just because the Fed is running inflationary policies does not mean that we will see inflation - it may just mean that we don't see deflation.

We have powerful deflationary forces at work: (1) government austerity; (2) de-leveraging; (3) the economic rise of China and other developing countries; (4) collapse of the housing bubble; (5) falling taxes on the rich (and equivalently rising use of offshore tax shelters.

Further, monetary policy has worked on the real economy through the housing market but that mechanism has largely disappeared.

"6. Government borrowing requires the Fed to buy bonds to hold down interest rates and keep the government from defaulting; this will cause/is causing/is defined as inflation."

This is not internally consistent. If Fed buying bonds causes inflation then by definition Fed buying bonds will increase interest rates.

I hear the same story with respect to the prices of treasuries. With all the record high debt levels why is the interest rate on the debt on not going up? Because the treasury is creating artificial demand by buying them up.

So the idea is that zimbabwe central bank buying zimbabwe bonds would cause a boom in the zimbabwe bond prices and reduce the interest rates to zero. Makes no sense.

SORRY but the zimbabué makes less sense,,,the zimbabwe bué don't have nuclear weapons, the biggest imperial banking system of the world and the north korea guys don't make 100 trillion notes of zimbabwethey prefer to forge fake banknotes in god they trust

Although there were 2500 prosecutions for passing forged notes last year and some pounds 25m was seized, one banknote in a hundred in circulation is a fake pouds dollars euros

but they don't forge fake banknotes von haiti or zimbabwe

ergo makes no sense this idea

the dollar have a fidutia value all around the world and is easier to have 10 thousand dollar's in bonds than the same value in copper or in silver or in scrap metalor in bean's you can, yes you can survive years with 10 thousand dollar's of beanswith some side effects

and the dollar failure is not near we pay 73 cents per dollarthe zimbabwe dollar are selling at 50 cents for 100 trillion banknote in the local flea market

syrian, chinese, japs, charlie (vietcong, vietmihn und so weiter buy american bonds germans buy US of A bonds Osama bin Laden use to have american bonds

Putin and all the people that is in a state of constant change have bonds that have been paid from records that endure at least 150 years

i don't have a record of default in american bonds

except this :The 1790 Default. Shortly after the formation of the first United States federal government under the Constitution of 1787, Congress passed and President Washington signed the Funding Act of 1790. This act directed the Secretary of the Treasury, Alexander Hamilton, to assume the Revolutionary War debts of the states, allowing creditors to exchange the state-backed war debt with bonds issued by the US Treasury. The interest on the bonds was deferred until 1801. A total of $21.5 million dollars was assumed.

Prior to the passage of the Funding Act, much of the debt was expected to default. It traded at deep discounts to face value. Once the act was passed, the value of the debt skyrocketed—because bondholders were sure they would be repaid by the new federal government. In fact, quite a lot of money was made by people who bought the state debt in anticipation of the Funding Act or with early notice that it had passed. Even at the time of the Founding, traders were profiting from informational asymmetries.

The Act also provided that the debt securities issued by the Confederation government that existed prior to the federal government would be converted into new federal bonds. The interest on one third of the value of the converted bonds was deferred until 1801.

So why is this described as a default by Reinhart and Rogoff? It’s pretty clear that the federal government was not defaulting on its own obligations. Instead, it was modifying obligations incurred by the states—either directly or through the Confederation—and assuming them.

This was almost the opposite of a default, since it made payment much more likely. That’s why the bonds rallied after the passage of the act.

The 1841-1842 Defaults. This was actually a series of defaults by nine state governments, including three states that repudiated their debt altogether. The federal government was not involved.

The 1873-1884 Defaults. Another series of defaults by states and cities. In total 10 states defaulted. West Virginia, the worst of the state financial basket cases, was still working out its debt with creditors by 1918. There wasn’t a federal government default, however.

The 1933 Default. In the summer of 1933, Congress passed the “Joint Resolution to Assure Uniform Value to the Coins and Currencies of the United States” which declared invalid and provisions of obligations of the federal government which were “purported” to give the creditor the right to require repayment in gold. The Roosevelt administration wanted to depreciate the paper currency, and thought the “gold clauses” contained in various bonds were an obstacle.

This is arguably the closest the US government came to defaulting. But this is more like monetizing debt than defaulting. It is closer to having the Federal Reserve inflate our way out of debt than what Rep. Ryan is proposing.

So no history of defaults?

To be fair to Reinhart and Rogoff, they don’t describe these as pure defaults—but as instances of defaults and restructuring. In this paper, they give more details on them.

It’s just not correct to say that the US is a serial defaulter—or to imply that we can predict the consequences of a default now based on past defaults. We just don’t have any historical data to tell us what would happen.

When it comes to inflation models, The emperor has no clothes. There are VERY FEW historical examples of hyperinflation. Therefore, a lot of factors correlate with hyperinflation without being causative.

There are very wealthy people who have a vested interest in cheap labor/ high unemployment. Are they pushing inflation fears to get policy that favors them at the expense of the majority? For sure, they have the money to "advertise" and are in position to be rewarded for their advertising.

Your #4"It might be in the interests of financial industry employees and financial media people to express a worldview where the policy conclusion is exactly what their clients and customers would like, while simultaneously placing bets against this worldview."

If this is the case, we are totally screwed because the BigF has more that enough money to deliver its message to the weak minded. A lot of finance money is made through predatory practices. Goldman Sachs was shorting the very mortgage securities they were pushing on the public. There are a lot of people running shell games that are acting in bad faith and poisoning our discourse. You do a great service in mocking them.

I cannot believe how confused economists are about inflation. Each level of money & asset class will should have its own inflation rate. But in the current system, "inflation" usually means inflation of m0 consumer prices, aka the Consumer Price Index (CPI).

The Federal Reserve chairman only focuses on consumer price inflation. But its excessive money printing usually doesn't make it to the level of m0 consumer prices because consumer prices are the main focus of the average citizens and the Fed serves the Rich. The money it injects into the economy is given to big banks. They either horde it in their reserves for security purposes or distribute it to Wall Street investors who use it to invest in stocks or houses. There needs to be separate price indexes and inflation rates for m0 consumer prices, m1 house prices, m2 loan prices, m3 stock prices, and m4 bond prices. Most of the money injected into the economy by the Fed has gone into the stock market, artificially inflating stock prices. The hard work of the employees of corporations and the wise decisions by some corporate CEOs that do increase the value of their corporations is confused with the excessive and illegimate extra money that is injected into professional stock buyers' hands by the Fed. This excessive free-&-easy money increases the risk-taking by stock investors. The stock market has become a casino. A crap shoot. Stocks are the preferred investment of rich people and the middle class invest most of their money in equity in their homes. Wall Street investors have been buying up residential real estate in the past several years for the purpose of earning rental income. The excessive money-printing by the Fed, which goes into the hands of Wall Street, has artificially inflated house prices and made them out of reach of many middle class homeowner wannabes. Our society is so fucked up. Fiat money and the Federal Reserve bank are the main culprits. No doubt about it.

"A world in which printing money doesn't have any clear link to inflation is a weird world indeed."

I cannot believe how stupid these economist-scientist eggheads have become. There is not a clear link between inflation and money printing because the only inflation they are focusing on is m0 consumer price inflation and the excessive money printing by the Fed goes into the hands of the Rich and they use it to buy stocks, not consumer goods. Gosh! I just want to punch these fuckers. Also, the excessive money printed by the Fed is used by the Rich to invest in other nations, which is known as the "carry trade" and "arbitrage".

Any finance professor will tell you that if a firm issues new liabilities at the same time that it gets new assets of equal value, then the per-unit value of those liabilities will not change. Unfortunately, the same finance professor will say that if a government issues new liabilities (i.e., money) in exchange for new assets of equal value, then the per-unit value of those liabilities will drop in rough proportion to the increase in their quantity.

By printing around $1 trillion per year and buying bonds the Fed has created a bond bubble. They could never sell the long term bonds for the price they paid. If they started to sell the bond bubble would pop before they unloaded much. The real bills doctrine says they need to stick to short term bonds so the value of the bonds does not change much and they can withdraw the bills they make. Because of this the finance guys are right.

Evidence, Vincent? Anything? Bueller? If what you say is true, wouldn't private sector buyers of bonds fear this and unload right now? Why hasn't Japan's "bond bubble" popped? Methinks this is probably not as easy as you think it is...

The timing is not easy because basically there will be a human panic to get out and it is hard to say exactly when humans will panic.

Japan is doubling the money supply and the interest rates on 10 year bonds is 0.61%. This is a bubble. It will pop. Just hard to say when.http://www.bloomberg.com/markets/rates-bonds/government-bonds/japan/

The quantity theory of money is highly unsatisfactory. You correctly note that money expansion by central bank only remotely affects inflation. The MMT's and many post Keynesians have long maintained that banks are able to create as much of endogenous money as they ever need. The exact method of creation provided is somewhat inaccurate. I tried to provide the missing details in http://olliranta.wordpress.com/endogenousmoney/

I think it's because they forget the "other things equal" clause, when they apply 1. They don't stop to ask *why* the Fed is printing money. The money printing *is* causing inflation, **relative to what the inflation rate would be without that money printing**, thankfully.

And they don't distinguish between temporary and permanent changes in the stock of money.

I am not so sure that the printing of money IS causing inflation, unless "inflation" is to be defined, not as general inflation, but as paper asset inflation, i.e. the prices of stocks and bonds.

But the prevention of deflation is a special linkage in this case, isn't it? Or perhaps two special linkages:

1. The money-printing prevents the crash of the banking system by propping-up the value of collateral in the repo market for overnight loans between the big banks. If this credit system crashed, then everybody who banks at these banks (i.e. absolutely everybody) AND had taken a loan to buy an asset, would be in bankruptcy court. In effect we would be sorting-out the ownership of the entire economy, in bankruptcy court, and that almost certainly WOULD cause deflation.

2. Wages are somewhat sticky downward, because Labor will not accept the phony reasoning that its OWN price-deflation is necessary, to save the system -- especially after the bank bail-outs! (however else Labor is regularly hornswoggled). In the big money cycle, sticky wages make sticky consumer prices.

It might help other people to understand why inflation will NOT necessarily happen, by adding this sentence, "they don't distinguish between temporary and permanent changes in the stock of money", the mechanical means, in this case: A) Financial repression, via zero interest rates as well as investors' lack of creativity and intelligence, and B) the fact that the Fed can unilaterally increase bank reserve requirements when the economy heats up, preventing the spillage of the extra moolah into the real (i.e. non-financial) sectors.

Preventing inflation at this point ought to be child's play, barring some new supply-side shock.

Nick - people will give your comment more weight than mine. I do think that tax cuts for the wealthy and the rise of offshore tax shelters are having a deflationary effect. Companies have engaged in a massive build up of offshore holdings hoping for tax changes - that cash build-up has to have deflationary effects.

Japan withdrew much of the new money it had made at one point. This is not normal, yet now the non-finance types can only think of Japan and miss all the data from many other countries where QE caused inflation. Academics can ignore 99% of the data and still publish but a finance guy that ignores 99% of the data will soon lose his money.

The key issue is that most people do not understand that monetary policy is rather tight than loose. Once people get that monetary policy is rather tight, they start to understand the rationale of QE and the rest.

In late 1960s, price of gas was about 35 cents; and one can buy a decent car at about $2500. We pay 10 times of those prices today. If incomes keep up with these rises, all is fine. However, incomes have not kept up and many (almost all, 99%) have been forced to retire on a fixed or dwindling incomes (near 0% rates and no assets in market because many cashed out in 2009 crisis) and savings. So the fear of inflation is very large in our society. And, any of your pet peeves are real to them; hence, the charlatans scream of inflation and make people invest in gold and many non-liquid investments (including annuities!). Besides, most have no time to learn about MMT or other econo nonsense when they can barely make ends meet.

So you're essentially saying that growing income inequality has led to a fear of inflation. See here:http://krugman.blogs.nytimes.com/2014/03/16/the-wages-of-men/?module=BlogPost-Title&version=Blog%20Main&contentCollection=Opinion&action=Click&pgtype=Blogs&region=Body

Emotionally, that makes sense. Politically, it leads to a perverse situation where the have-nots keep clamoring for low-inflation low-growth policies that hurt them and help the haves even more.

This perverse situation also perverts the politics and leads man to adventure in wars at tremendous expense of lost human potential and heritage. All that is left is fear, abject fear. Economists do not consider the total cost of their pet peeves in our society.

May I offer a mild objection to your 2nd reasoning why this inflation hysteria persists. Maybe simple minded monetarists might say such things but Milton Friedman was not a simple minded person. He in fact advocated a more aggressive version of QE during Japan's deflationary period. Something tells me that if he were alive today - he would have been advocating that the FED follow what Professor Bernanke used to preach - at least before he became the FED chair.

Noah Smith writes, "So how does one extract an individual human mind from this hive mind?... So far, these are the only things I've found that work. If you have any other ideas, please share." I will try, but it comes from outside the economics discipline! I followed the economics discussion since the crash and put it into a series of animated flowchart cartoons. The first is a summary, then this series returns to the basics, and explains things bit by bit:

This is outside traditional economics pedagogy, and, after some of the comments above, my suggestion may be perceived as from yet another crackpot.

One reason is because economists are wont to use mathematics. My argument (elsewhere) is that mathematics is of limited use in understanding the whole economic system, because of two foundational problems, calculational and algorithmic: 1) the economy is an N-compartment model (in these cartoons, domestic macro is in 4 compartments) and so attempts to predict go against something analogous to the N-body calculation problem. 2) The economy contains humans, which add uncertainty because creativity and preferences are unpredictable emergents, and are beyond algorithmic machinery whether by pencil or computer.

So my intention is illustration, not prediction.

What fascinates me to this day is that economists, even Paul Krugman, do not come right out and SAY WHY the Fed printed the money, in everyday terms. (That is, not in technical economics terms such as IS-LM terms.) It is not merely a "stealth bailout of big banks", as Noah Smith wrote. After the crash, printing preserved the general structure of asset ownership of everyone in the economy, not least the 1%, by saving their banks. Otherwise absolutely everyone would be in bankruptcy court even today, trying to reclaim ownerships amid property deflation.

My little cartoons show what is most important for a mind hoping to escape the hive: The financial sector has internal markets which have their own logic, slightly divorced from the real economy (i.e. the economy of real, i.e. non-financial, goods and services). Systemic risk is possible, and financiers really aren't as intelligent as they are greedy.

The unregulated repo market (overnight loans to shadow banks, analogous to the fed funds market between depositories) rivals the dollar size of the real GDP. The loan collateral in this market used to be only Treasuries, but then mortgage derivatives began to be used. A nice book was written by Gary Gorton.

Thinking this way is very dangerous, because you will realize the private capitalism is not entirely effective, and its dodginess can start to hurt other people. The financial system must be put under much tighter regulation and transparency, against accounting control fraud.

You will also begin to see that there may be other cases in which the government should print the money, perhaps regularly -- most especially as a monopsonist in the basic healthcare market, which has a number of fundamental problems on both the supply and demand side.

"So how does one extract an individual human mind from this hive mind? That is always a tricky undertaking. But I've found two things that seem to have an effect:

Method 1: Introduce them to MMT. MMT is a great halfway house for recovering Austrians.

Method 2: Introduce them to the research of Steve Williamson. Williamson is an example of a guy who changed his mind about the most likely effect of QE, after observing its real effects.

So far, these are the only things I've found that work. If you have any other ideas, please share."

Look, Noah's got it all wrong! The believers in the Macro Finance Canon don't NEED to follow MMT or Stephen Williamson, they don't NEED to follow ANYBODY! They've got to think for themselves! They're ALL individuals!

Vincent,I already commented on a particular aspect of "how we know inflation is coming". I truly appreciated both your generousity and promptness with respect to the issue involved. But I still think the empirical evidence is against you.

The only thing I really disagree about with respect to your "corrected MMT" post is your implied conclusion. I don't think that central bank independence is in danger anywhere in the advanced world (just in countries like Argentina).

Mark, in Japan it looks to me like Abe has already replaced the head of the central bank with his man, so the takeover has already happened. The old independent central bank was not going to double the money supply in 2 years.

Vincent, the previous BOJ Governor's 5-year term expired. The cabinet nominated a successor and the Diet approved. Absolutely no change in the BOJ's political independence occured. According to the Bade and Parkin scale of central bank independence, the BOJ is more independent than any advanced country central bank with the exception of only the Fed, the ECB and the SNB. In fact if the policy records of the BOJ, the Fed, the ECB and the SNB are any evidence (all are bordering on deflation), the advanced world suffers from excessive central bank independence, not too little.

Recognizing that money demand is also endogenous and more importantly, inversely related to money supply will help people make sense of what's been going on. Both active fiscal and monetary policy manipulate the money supply, but have little to no impact on money demand. Since demand for money is outside of government control, it places a constraint on both fiscal and monetary policy. What we are observing today is the constraint placed on monetary policy by high demand for money. Back in the 60's and 70's, low demand for money constrained active fiscal policy producing inflation. I explain in more detail here http://tinyurl.com/k3kn3e9

Noah -- Doesn't it make more sense to look at what finance does rather than what finance guys say. Look at the big hedge funds and the proprietary trades of the big IBs. Have they made big bets on inflation because of QE? PIMCO went that direction briefly but quickly backed off. Kocherlakota shifted pretty quickly as well. People with real responsibilities or managing real money are finance, not a-holes like Schiff.

Noah -- I guess I mean that the "cannon" is talk and not to be acted upon so that it isn't really a cannon.. I guess your'e looking for a reason they say things they don't do. Is that what you're getting at?

If finance includes the Fed and reports from the GS chief economists than the cannon doesn't say what claim. They were not predicting inflation. If you take the hucksters that don't manage money -- Grant, Schiff, and retail newsletters -- than OK. But that's a weird cannon if it includes Schiff but not the Fed or GS.

With respect to the Europeans, that's easy -- it's good for Germany to have an internally overvalued currency for trade and for politics. The BIS worries only about creditors so they're talking their book.

NO, only 40% OF the trade in eurozone is internal trade, and poles, brit's romenians and others make more than 30% of the EEC population and they don't use euros.....it's not good for germany in the long run...they don't sell only BMW's and Mercedes they use to sell plenty of services and industrial machines that the south and the east of europe don't buy anymore...

and they are dumping this machines in asia until ......the chinese produce the same machinery some coal mining machines in china are better than the germans endure superior pressure and the cost is half the germanic are losing alot

Not arguing the long-run equilibrium. Germany is doing quite well relative to the EU in terms of employment and are a significant net exporter. German economists shill for the politicians and exporters pushing for austerity. As I said, they are serving their overlords well.

The money multiplier description of money is just plain wrong. Transaction balances are an account of what a bank owes to its clients, not something lent to banks that they then lend on to borrowers. These balances need to be created by banks when they lend, and are then used as money.

When everyone who can borrow has borrowed as much as they want, then no more borrowing will occur, and no more money will be created. The central bank is no more a creator of money than any other bank, as can be seen from history where money existed in many times and places in complete absence of a central bank.

You are totally right. In times of prosperity, banks over create loans without the need of real deposits. The paradigm of money multiplier is obsolet, as you claim. This leeds to a situation of over indebtness and unstable equlibrium (Minsky) and balance sheet recession (Richard Koo). Monetary stimulus does not work anymore: negative interest rates, QEs, asset purchase programe ...

Richard Koo is right with the diagnostic, but wrong about solutions: public debt growth can provide the money that needs the private sector to fight against debt-deflation (deleveraging process destroy money supply M1/M2). And is wrong since Japan is trying to do this since 1990, without succeed. And America is on the same way: the growth is a statistic scam. The real unemployment is much bigger than the official rates, and GDP growth is nothing to do with real business growth.

I hope some day (maybe after two or three more crises) the mainstream economists will find the real issue in here: how credit expansions created by central banks (artificial interest rates modification), creates at the same time, overinvestment and overconsumption, providing a distorsion in different production stages. It can be seen clearly in real state boom in USA or Spain, where interest rates couldn't rise up when the economy started to heat. Why? because central banks continue to push interest rates down. In a real interest rate enviroment, protobubles can be stopped in realy stages of growth, because is naturally impossible to overinvest and overconsume at the same time. Impossible.

I agree we have not gotten inflation yet, but what is wrong with our logic? Seems almost tight a tight proof. Just not sure of the timing.http://howfiatdies.blogspot.com/2014/01/how-we-know-inflation-is-coming.html

the effects of the money supply growth is different according to the country. For instance, in countries with low developed financial market, like Venezuela or Argentina, you can see literally which are the effects of money supply. In Venezuela, from 1999 to 2012, inflation reached an accumulated 1.200%, and the consequences are evident.

In countries with a developed financial market, like usa or japan, inflation goes to another kind of assets. After QEs, you can see the effects in food price index, commodities like oil, emerging markets capital inflows, etc.

Right now in USA you do not have inflation, because all bank reserves are going to another direction except to real economy, i mean, to real loans to real business. Why? because like MMT (and Minsky in another way) teaches, loans create deposits in times of "prosperity". When crisis hit the economy, loans do not create deposits anymore, since demand is not solvent anymore. As Richard Koo claims, society, as an aggregate, prefer to return debt before obtaining new debt (the net result is returning debt = debt deflation). Even the Bank of England recently is providing this explanations

The big issue in here is that this keynesian view of the economy, it means, that the fall of the aggregate demand has to be counter balanced with monetary inyections (low interest rates, QEs, etc.), is demostrated that is not working at all. We just have to look at Japan, and its 230% GDP debt growth 1990-2012, with just a GDP nominal rate growth of 0,2%, or the actual Abenomics, that are messing the economy. Even Raghuram Rajan is aware that something is not working at all with this stimulus programs:

So at the end is a matter of fact of what america is going to do when growth comes again with its huge amount of M0 deposited in commercial banks as reserves, and if society is going to be able to absorbe in form of GDP.

Just a few thoughts:* Velocity: often used to explain why no inflation. However, v is a dependent, not independent variable. You cannot say that v should be, say, 2 or 3. It is simply a quotient.

* Inflation: Maybe there are different ways of inflation. Gary Shilling wrote about "7 ways of deflation". Inflation could be imported, driven by raw materials (crude), by price-wage spiral and tight labor market, by excess purchasing power relative to goods produced or by loss of faith in fiat money.Why has inflation not manifested itself? Our economic system is debt-based. TCMDO (Total Credit Market Debt Outstanding) is $59trn, not counting unfunded liabilities. Yes, there are a lot of assets on the other side of the balance sheet, but those are not in the same hands (income / wealth inequality). A debt-based economy is dammed to grow. If number of citizens and productivity shrinks, the system becomes unstable very quickly (debt/GDP just keeps going up, even with balanced budget). Annual population growth in the US has slowed to 0.7%. And maybe we have squeezed most productivity gains out of the production process already.

* Debt: Increasing debt levels allow for faster consumption / investment, and can be inflationary. High debt levels, however, have a deflationary effect. So maybe we are just at the point where both forces are almost equal?

*Fed: according to Jim Rickards, Fed NEEDS to engineer inflation (real GDP growth is too low to carry the debt burden, so nominal GDP growth has to be pushed higher via inflation). They are trying pretty hard, and look what they have achieved. Nothing.

So there must be something evil about inflation: it's hard to kill when you don't want it (1980's), but also hard to engineer when you need it (now). Maybe the economy is too complex of a system to be dialed up and down as some central planners please. There is non-linearity involved, and economists' models can't figure out how reality works. It's probably not a coincidence nobody uses the DSGE-model but the Fed.

well, Krugman is post-keynesian, and still believes that economic multiplier is still valid. So an economist that still uses old economic models, wouldnt be trustworthy. In the other side, MMT and Austrians teach since decades that commercial banks credit expansions (credit-money creation) distort interest rates, saving and consumption behaviours, and capital structure because of bubbles.

May I add a psychological motivation. You did history at a second-tier university, and now you are a portfolio manager. You have to make macro calls to do tactical asset allocation (actually, you don't have to -- you could just make portfolios and leave them alone -- but you think you do). Then you find a reassuring set of doctrines that says 1) it's all pretty simple and 2) those pointy-headed academic types with their incomprehensible maths just don't get these simple facts that you can apprehend by "common sense".

As to why: #4 all the way (which depends on #1-3 to varying degrees). I think if you look at the revealed beliefs based on "smart money"'s portfolios, Wall St doesn't really believe in such BS. They just have to speak that language to defend the rentier class, and to justify whatever it is they need to justify. E.g. "My product's not working? Blame QE's 'distorting effects' (whatever that means)!" "You want passive management? You need to be active, to avoid the bubbles (who knows where they are) that will burst when QE is tapered down!" Etc etc.. it's a scapegoat, nothing more.

So I would say that there are a few factors (some related to basic stupidity, others far more insidious) that in various combinations would explain the macro-finance canon.

Firstly, you have to realize that enormous sums of money have been made through

(1) Judicial and Regulatory capture (think of the PE funds and their masters)(2) Plain misreading of the economy/market combined with a zealot's determination to "stick to the trade" had resulted in absolutely enormous profits in the sub-prime saga (think of very large hedge funds, whose thesis behind the short was essentially was that with mortgage rates rising, people would not be able to refi or buy new proerty leading to the collapse of the markets. The same funds' performances subsequently lend credence to the notion "easy come easy go" for almost all investors except.....)

(3) One has to believe that there is an influential coterie of leaders (in the government, the Fed and certainly Wall street in general) that are influencing policy for themselves and in their capacity as effective water-carriers for plutocrats, who wish to perpetuate deflationary tendencies that lead to re-distribution of income and wealth. In their direction that is.

(4) Perhaps (and here I am fairly certain) that monetary policy and its expansion, combined with regulatory changes have meant that the transmission mechanism is actually quite ineffective under ZIRP. "Money Printing" won't work in causing inflation unless a good portion of it goes to the hands of the unwashed masses, in the form of re-distribution in the opposite direction than currently in action. So. Fiscal. Policy. Please.

The antidote for these views is Monetary Realism. Once it is clear that loanable funds is an anachronism and that currency isn't dropped by helicopter via monetary policy, all this shit becomes a lot clearer.

Don't challenge their views. This never changes minds. Instead agree with them. Get them to say "yes". Ask questions like- doesn't deflation correlate with high unemployment- doesn't high unemployment correlate with reduced real wages and purchasing power?- aren't there markets in all things?- what does the evidence suggest for the supply and demand for money?

Don't tell them the answer. Lead the way and let them figure it out for themselves.

You are not accurate. Unemployment, debt deflation, and falling wages and purchasing power are the consequences of a _cause_, and this cause is missallocation of resources because of a credit expansion creating a bubble.

According to you, countries that suffered a housing bubble, do not need to reallocate resources, umemployment, money, or capital structure, because in reality, the country didn't suffer a bubble (huge percentage of GDP involved in real state). Its "just" an aggregate demand fall cause by an irrational and anjustified behaviour, so the goverment policy has to inyect money to pump up aggregate demand, so that the bubble do not stop. It means, the consumption and investment in housing should continue. It doesn' t matter if the country has built double houses that they need. The industry has to continue.

Others think that unemployment, falling prices, actual missallocated industry liquidation and reduced real wages are the inevitable _consequences_ of a credit expansion. If you do not release this resources to start _investment_ in new business in another sector different than real state (or wherever), if you dont increase real savings, if you dont let wages decrease in sectors that experienced a huge increment ...

... you dont get out of the recession and crisis. The more you stimulate aggregate demand through money expansion, the more you let this missallocated industries network to refinance their unsustainable bussiness (¿constructing more houses?), the more you dont let assets fall to not bubble prices .... the longer you make the recover.

Japan is almost 20 years trying to stimulate aggregate demand without success ...

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